In a recession, you would expect a fall in the inflation rate. In basic macroeconomics, we would teach.
If AD falls (or increases at a slower rate than AS), then the economy will experience spare capacity. If there is spare capacity in the economy, firms will tend to reduce prices (or a slower inflation rate).
Diagram showing fall in AD and effect on Price Level.
Why Spare Capacity can lead to lower inflation
- Firms have unsold goods, therefore, to improve cash flow they try discounting goods to sell excess supply of goods.
- As unemployment rises, it is harder for workers to bargain for higher wages. Unemployment should reduce wage inflation, which feeds into lower CPI inflation.
- A global recession should usually reduce demand for commodities and therefore reduce the price of commodities.
- Low confidence in economy usually reduces inflation expectation.
Spare Capacity in the UK Economy.
Spare Capacity in UK Source: Paul Fisher Bank of England
This graph shows the UK theoretically should have a lot of spare capacity, therefore, we would expect inflation to be lower. However, inflation hasn’t fallen, but increased recently.
UK Inflation: Source: B of E speech 29 June 2010
Why Inflation hasn’t Fallen
- Impact of VAT. The cut in VAT to 15% and later rise (Jan 2010) to 17.5% increases prices.
- Impact of Depreciation in value of Pound. Fall in value of pound increases cost of imports which feeds into inflation
- Rise in oil and hence petrol prices.
- Rise in spare capacity is less than expected. Helped by zero interest rates, there have been less insolvencies than in previous years. Also the rise in unemployment is less than in previous years
- Firms have sought to maintain good cash flow by not cutting prices.
All these are reasons why inflation hasn’t fallen by more than expected. But, one interesting fact is that UK inflation is much higher than our main competitors like EU and US.
The big question is whether UK inflation really is due to short term temporary factors or whether, it will feed into higher inflation expectations.
Further Reading
- Why is CPI Inflation so High – Paul Fisher 29 June 2010
- Inflation or Deflation?
- Definition of Inflation
Spain has got it bad with around 20% of their people out of work. However Greece have it worse and I don’t even want to know how many people don’t have jobs.
In Romania, in full recession, instead of lowering the VAT, they increased it from 19% to 24% making this way the inflation go higher.
The key issue in the Uk is the devaluation of the pound vs the dollar, and critically the extent now of global integration.
In past recessions capacity has been created, now with most manufacturered products made in the Far East and even for Uk manufacturers components sourced from the Far East, the capacity is created there.
It has made the Uk economy much more able to cope with the recession, but has caused both higher than expected inflation and lower than expected unemployment.
Expect Inflation to increase fast, unless Interest rates go up.
You also have to consider the role of the consumers’ reliance on credit to continue to purchase goods. I’ve been amazed with how resilient the consumer has been during these tough times. Inflation may really get out of control once things get better.
Well, with regards to why inflation hasn’t fallen: One of your strongest points indeed is the depreciation of the UK pound relative to other currencies (in particular the dollar). Something very similar actually happened during the Great Depression in the 1930s. Countries that stayed on the gold standard could not devalue their currencies and thus internal deflationary pressure was forced upon them. Countries that abandoned the gold standard earlier could devalue their currencies and could thereby also raise their domestic prices – inflation.
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